Bush Credit-Crunch Plan Is on Target

There is considerable debate these days about the credit crunch.

An often-heard refrain from those who say there is no crunch is "there is plenty of credit available for good borrowers."

While this assertion is correct, it is also irrelevant.

Of course 24-karat customers can get credit. Perhaps 18-karat customers can also qualify today. But what about 14-karat or 10-karat customers?

Credit crunches always hit the marginal borrowers. The severity of a crunch is signaled by the number of layers of marginal borrowers denied access to credit.

The Crunch Exists

In the past few weeks I have spent a great deal of time talking about the credit crunch with the top executives of a couple of dozen banks, of all sizes. A few things have become clear.

We are indeed experiencing a credit crunch. People to whom banks would once have extended credit are being denied it, or the banks are demanding such onerous terms as to drive them away. Businesses, too, are getting such treatment.

What is causing the crunch? Some say it is regulator-driven. Some blame it on a lack of loan demand, because of the recession. Some contend the Fed is being too stingy with the money supply. Others argue that many bank customers are already too deeply in debt.

These explanations are all correct; no single one is sufficient.

Let's Look at Regulators

We can't do much in the near term to remedy the excessive debt burden or the recession-caused lack of loan demand. So it makes sense, if only to avoid feeling frustrated, to focus on the money supply and the regulatory environment.

Three of my colleagues have doctorates in economics and become annoyed when I dabble in their field, so I'll skip the money-supply issue and concentrate on regulation.

I have not the slightest doubt that the current credit crunch is in large part regulator-driven.

The government blew it on the savings and loan debacle. Supervision and regulation were somewhere between minimal and nonexistent, and Congress' behavior was deplorable.

Now everyone - Congress, the General Accounting Office, the regulators - is approaching the banking industry with born-again fervor. Capital standards have been raised. Amid a recession, deposit insurance premiums have been trebled.

Markdown Mania

An even more serious problem is that examiners, appraisers, and auditors are marking bank assets to liquidation values with abandon.

Let me describe an actual case. A large bank had a business park on its books for $57 million. The appraiser took into account four factors:

* Current sales prices (they were down).

* Expenses of operation.

* The current absorption rate (almost nil; it would take 18 years to sell the parcels at the current rate).

* The discount rate (it was assumed that a buyer would need to put up 50% equity and would expect a 20% compound annual return on the equity).

The bank was required to mark down the project from $57 million to $10 million.

Hamstringing the Banks

This approach to valuation of bank assets has two extremely pernicious effects.

First, the writeoff of $47 million depletes the bank's capital and reduces its ability to lend by about $500 million.

Second, forcing the bank to mark long-term, cyclical assets to current market value ensures that the bank will never again finance such assets - at least not on terms many borrowers will be able to meet.

It's hard to blame the examiners, appraisers, and auditors for producing these kinds of results. They're running scared. They've watched the congressional hearings; they've seen their colleagues' careers ruined; and they've read about the lawsuits demanding billions in damages.

A Plausible Approach

The Bush administration has finally put out a sensible program to ease the credit crunch.

It requires issuance to examiners of new asset-valuation guidelines and monitoring to ensure they are being followed.

It liberalizes capital standards by letting preferred stock be included in Tier 1 capital.

And it recognizes the chilling effect on lenders of extremely liberal bankruptcy laws and the imposition of lender liability for environmental cleanup costs.

All in all, the administration's proposals are a very good beginning. Follow-through is required to make sure the program is carried out as intended.

If it proves insufficient, the administration must be ready with stronger measures.

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